Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Saturday, September 03, 2011

UK Regulator Will Improve Independent Audit Report and Enhance Role of Audit Committees

Calling the outside audit report on company financial statements a wholly uninformative product of an opaque audit process, the UK Financial Reporting Council plans to propose an expanded audit report that includes a new section addressing the completeness and reasonableness of the audit committee's report and identifying any matters in the annual report that the auditors believe are incorrect or inconsistent with the information contained in the financial statements or obtained in the course of the audit. The FRC will also propose revisions to the UK Corporate

Governance Code extending the remit of the audit committee to include consideration of the whole annual report, including the narrative report, to determine if the report, viewed as a whole, is fair and balanced. As part of the reforms, the FRC has declared war on boilerplate text, describing it as ``pernicious’’ in the way it obscures what investors need to know. The FRC noted that both the PCAOB and the IAASB have recently published papers discussing possible changes to the way auditors report on audited financial statements. In formulating its proposals in this area, the FRC said that it has taken into account the PCAOB and IAASB initiatives.

In its reform of the independent audit process, the FRC said it would be guided by three principles. First, preparers, audit committees and auditors must ensure that all material issues are reported in a manner that is complete, neutral, free from error, fair and balanced. Second, auditors must exercise professional judgment when undertaking audits and adopt a challenging or appropriately skeptical approach to key issues, assumptions and evidence. Three, both the company and its auditor must be satisfied that the annual report, taken as a whole, narrative and financial statement components, is fair and balanced.

With the end of the consultation period and specific proposals being readied, the FRC believes that more needs to be done to demonstrate that auditors are achieving the fundamental purpose of an audit, which is to carry out an independent check into whether a company's financial statements, including the decisions, judgments and estimates involved, have been properly prepared.

To achieve this, auditors should provide increased insight into the audit process and reassure users of financial statements that issues material to the financial statements have been properly disclosed. At the same time, the FRC believes that the primary responsibility for providing this information rests with the company. Thus, the FRC will propose that audit committees should produce reports fully describing those important judgments and other matters addressed in the course of the audit.

The FRC will propose changes to the standards governing the provision of reports by auditors to audit committees designed to ensure that auditors are required to provide audit committees with the information they need to understand fully the factors that the auditors relied upon in exercising their professional judgment in the course of the audit and, in particular, in reaching their audit opinion. Those are likely to include, at a minimum, the auditor's views on: the effectiveness of the company's system of control, the judgments made in the audit plan about what is of material significance and the implications of those judgments for the level of assurance provided by the audit, the appropriateness of the accounting policies, their overall conclusions on the valuations of the company's assets and liabilities provided by management, and any other matters identified in the audit plan or by the audit committee as material to the proper presentation of the company's financial position.
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Because it believes that the responsibility for communicating key information to shareholders lies with company leadership, the FRC rejected an idea to require outside auditors to provide their own commentary on the financial statements. The role of the independent auditor is to review a company's annual report, including its financial statements and provide a second opinion on whether they have been properly prepared. The FRC will avoid a reporting structure that undermines the duty of company directors and management to provide key information. It does not believe, therefore, that auditors should be placed in a position where they might be required to perform a management role.

Policy makers have focused on the importance of professional skepticism in the outside audit, in particular the question of whether auditors were adequately skeptical in the run up to the financial crisis. This area is the subject of a separate initiative by the Auditing Practices Board,, which is part of the FRC, to draft guidance on the essential characteristics of professional skepticism. The Board is considering revisions to the standards governing the management of audit practices to ensure that professional skepticism is promoted and developed.

In order to address concerns about the duration that some companies have the same audit firm, the FRC will propose amendments to the UK Corporate Governance Code and the related Guidance for Audit Committees requiring companies to put their audits out to tender at least once in every 10 years, or explain why they have not done so. So that there is time to undertake an effective and open tender process, audit committee reports should announce that, absent unexpected developments, the company intends to put its audit to tender in the forthcoming year rather than announcing it has happened after the event.

The FRC will also require audit committees to explain, in their report published in the company’s annual report, the steps that they took when deciding whether or not to put the audit out to tender and their reasons for proceeding in the way that they did. For example, audit committees will explain why they did or did not go to tender and, if they did not, when a tender was last conducted. Audit committees must also explain why they decided to reappoint the existing auditors; or why they appointed new auditors.